Lawmakers have a lengthy to-do list. The 2% Social Security payroll-tax cut for employees expires at the end of 2011. So do a host of other provisions, including a fix to keep the alternative minimum tax from expanding to millions more taxpayers in 2012, and an extension of the popular IRA charitable contribution for people older than 70½.

Other changes are set to take effect at the end of next year, including the expiration of the tax cuts enacted in 2001 and 2003. The top tax rate on wages would reset to 39.6% from 35%, and the top rate on long-term capital gains would rise to 20% from 15%. The special 15% rate on dividends would lapse, as would the current generous estate-tax provisions. As many 10 million lower-income families and individuals would also be restored to the tax rolls, according to the nonpartisan Tax Policy Center.

Don’t be fooled: Tax Court judges are people too. They live and laugh and love, just like the rest of us. Their highfalutin position may require them to carry themselves with an excess of formality, but deep down, they all eagerly anticipate that rare moment when the court loosens the shackles and allows them to have a little fun.

And when it happens, as it did last week in Willson v. Commissioner, the results can be both entertaining and educational. Because when formality is sacrificed for simplicity — as Judge Holmes did in authoring his decision — the takeaway lessons of the case are often easier to absorb.

First, some background: the taxpayer (Willson) chose “S case” status, which allowed him to introduce evidence that would otherwise not be admissible, but more germane to this blog post, also permitted the Tax Court to conduct the trial as informally as possible. Which it most certainly did.

Willson was a bit of an entrepreneur, though not necessarily by choice. He built a bar in 1986 after a gunshot wound prematurely ended his career as an auto mechanic. Willson made considerable improvements to the bar and the surrounding parking lot, only to see the majority of the property burn down courtesy of some faulty hair-band pyrotechnics.

But perhaps we’re best served letting Judge Holmes explain the events leading up to the fire, as he does it quite eloquently; throwing in a brief history of the evolution of late 80’s rock for good measure. His words resemble those not of a reputable adjudicator, but rather those of a disillusioned codger ruminating on all that’s wrong with the world from the sanctity of his front porch, pausing just long enough to implore the neighborhood kids to get a haircut.

His words are, however, awesomely refreshing in their informality:

With these new stages, the bar became a local mecca for a type of “rock and roll” called “glam metal.” We also took judicial notice that “hairbands” had lost much of their popularity with the coming of something called “grunge rock” (another type of “rock and roll” music) in the early nineties. This was important to Willson’s business because “hair bands,” with such unlikely names as Head East, Great White, and Saturn Cats could still draw large crowds to a bar on the outskirts of Des Moines but had become affordable providers of live entertainment. Willson even invited one of these “hair bands” to be a sort of artist-in-residence. One night in 1994, a few band members did something to a smoke machine that sparked an enormous fire. This fire engulfed everything except the parking lots, the shed, and the property’s original house.

And with that I give you the first — and almost certainly the last– mention of Great White you’ll ever find in a Tax Court decision.

Undeterred by his bad fortune, Willson rebuilt the bar and rented out a portion of it to a new business; one that employed the type of women who was once a staple in the videos of the very 80’s music that caused the demise of the bar in the first place. Circle of life, I guess.

As Judge Holmes put it:

Willson rented out the old space to a tenant who installed minor improvements and opened an establishment felicitously–and paronomastically–called the “Landing Strip,” in which young lady ecdysiasts engaged in the deciduous calisthenics of perhaps unwitting First Amendment expression.

Now, we here at Double Taxation fancy ourselves as fairly bright individuals, but we’re not ashamed to admit that we only recognized about four words in that sentence. For those of you without a Word of The Day Calendar handy, here’s the best translation we could muster: Willson opened a strip bar with the clever name: The Landing Strip.

In 1999, the city of Des Moines began condemnation proceedings against Willson. Unfortunately for Willson, he wasn’t around to oversee the dealings with the city, as he was about to begin serving a federal prison term for, as Judge Holmes put it, “…something to do with money and drugs and possibly the bar.”

Willson eventually received $203,427 from the city in exchange for his property, leaving the Tax Court to determine the amount — if any — of the gain resulting from the condemnation.

Now typically, the Tax Court has a way of needlessly complicating even the most seemingly straight-forward of concepts through the required references to the statute, regulations, administrative procedures and a near-century of case law, all delivered in the standard legal mumbo jumbo.

And therein lies the beauty of an “S” case: Judge Holmes was permitted to explain the concepts of “amount realized” and “adjusted basis” for purposes of computing Willson’s gain or loss in layman’s terms, which can be a tremendous benefit to young CPAs struggling to grasp these intangible concepts.

Someone who sells property is taxed on the gain, not the sale price. This gain basically depends on two other numbers: the amount the seller receives and what is called “adjusted basis.”

The amount the seller receives is not just how much cash he pockets. It also includes, for example, money that goes to pay off other debts tied to the property. The amount that Willson received in this sense (called the“amount realized”) is $203,427.

That leaves us with the “adjusted basis.” To figure out Willson’s gain, we have to subtract the adjusted basis from the amount realized. Basis is pretty much what a property owner paid for the property plus what he later spent to improve it.

A taxpayer can’t generally deduct these payments right away because they provide a benefit that lasts longer than just one taxable year. But before calculating the capital gain the basis must be adjusted under section 1016. And depreciation is one of those adjustments we need to figure out in this case.

Most property doesn’t just fall apart one day, it suffers wear and tear over time. That’s why the Code allows a taxpayer yearly deductions for depreciation over the estimated useful life or recovery period of the property used in a trade or business.

When it was all said and done, the Tax Court held that Willson actually generated a loss on the condemnation, but not before also working through the implications of an involuntary conversion under § 1033 on Willson basis (upon recovering insurance proceeds after the hair-band fire.)

Rare is the day when the Tax Court releases a 77-page decision with nary a learning point to be found — as it did today in Powerstein v. Commissioner, T.C. Memo 2011-271 — but that’s not to say there wasn’t something worth blogging about within those 77 pages. In fact, one could argue that the Tax Court’s decision in Powerstein was as important as any in recent memory, as it settled a question long pondered by shiftless layabouts and frat boys alike: How much cash does the average person spend on alcohol in a year?

Allen Powerstein was, at various points in his life, a war veteran, a CPA, and a criminal. And while the court shed no light on Powerstein’s mettle as a fighter, if he was half as inept as he was at his latter two vocations, America’s struggle to defeat Vietnam in a ground war starts to make a bit more sense.

As a CPA and criminal, Powerstein was equal parts unethical and stupid: not only did he continuously rip off the IRS by understating clients’ income and overstating or fabricating deductions, he meticulously documented his shenanigans in correspondence with said clients. For your amusement, I’ve reprinted one of these letters in its entirety at the end of this post. I highly recommend you read it, if for no other reason than you’ll go to bed tonight feeling much better about your personal ethical boundaries.

Powerstein filed equally improper returns on his own accord, grossly understating his income for over a decade. The IRS eventually caught on, and Powerstein was subsequently convicted on tax evasion charges and sentenced to 63 months in prison in 1994.

At issue in today’s decision were Powerstein’s tax returns from 1984-1989. As he had failed to keep any relevant documentation, the IRS used the “net worth” approach to recreate Powerstein’s taxable income for those years. The “net worth” approach is one of several options the IRS has at its disposal to compute a taxpayer’s tax liability when either a return is not filed or reasonable supporting documents are not maintained, and it involves four steps:

1. Computing a taxpayer’s net worth at the beginning and end of each year at issue;

2. Taking the difference between a taxpayer’s net worth from the end of the year to the beginning of the year;

3. Decreasing the amount from #2 for nontaxable receipts, and

4. Increasing the amount from #2 for nondeductible personal expenses.

For a solid 50 pages, the Tax Court meticulously recreated Powerstein’s income, haggling over such minutiae as whether he was entitled to a deduction for a $230 copier and much more importantly, how much he was entitled to deduct each year for alcohol purchases.

After an analysis of the relevant factors, the IRS permitted Powerstein an average of $280 in annual booze allowance, in part because Powerstein supported his son-in-law, a court-described “social drinker” with a DUI to his credit. A quick search of the IRS website revealed the table used to reach this determination:

Now, back when I was 24, single, and cool (Ed note: author was never cool), I’d call $240 worth of booze “Tuesday,” but hey, Appletinis ain’t cheap.

Now older, married, and constantly sleepy, I’ve lost touch with whether a couple hundred bucks a year of booze is reasonable. Clearly, its location dependent, as a coal miners bar in Western PA is undoubtedly serving up drinks (read: beer) at 1/4 of Manhattan prices, but in general I think it’s probably fairly accurate, unless you’re hosting parties or rollin’ with Lindsay Lohan.

Please discuss.

Below is the letter from Powerstein to his client. Enjoy.

Received your recent letter and IRS letter regarding the 1983 taxes. Before I explain the real meaning of their letter, I must point out that I am not surprised that we got such a letter and that the IRS computer is accurate in tracking bank interest reported on 1099s. We must carefully reply to [the] IRS and explain what we did and if there is any additional tax to pay, and I am not saying there will be, we will pay it at the appropriate time.

Here is why I like their letter:

1) I reported the Ford pension of $4,634, but showed the entire amount to be non-taxable and the IRS did not question this. I know you are both aware of this.

2) I claimed Airlift International as a worthless security in the amount of $4,251, however it really cost you $1,251. IRS did not question this.

3) I claimed a $2,000 exclusion for All-Savers Certificates at American Savings, when in fact you never had an All-Saver Certificate. IRS did not question this.

4) I claimed a $200 exclusion against the Merrill Lynch dividends. These dividends do not qualify for the exclusion. IRS did not question this.

5) I claimed 3-additional exemptions * * * which the IRS did not question. Each exemption is $1,000 or a total of $3,000 which we are really not entitled to.

6) I claimed a political party contribution credit of $100. IRS did not question this.

7) I claimed a residential energy credit carryforward from 1982 which the IRS did not question.

Please understand that the IRS sends these letters out to anyone who fails to report the amount

shown on the 1099, namely in our case Chase Federal. The CD penalty is something else. This is a routine letter but important to answer on time. Just think if they decided to audit the return on all the points I raised in the early part of this letter. You would owe a fortune. Speak to noone at the bank about the IRS letter but only that we need an amended 1099.

Benny Nipps was named the beneficiary of his cousin’s IRA. (Ed note: While the court did not disclose the cousin’s name, let’s all just agree it was Seymour so we can giggle through the remainder of the post)

Unfortunately for Nipps — or fortunately, depending on his financial circumstances -his cousin died in 2007, leaving Nipps approximately $45,000 in inherited IRA moneys.

Upon receipt of the distribution from his cousin’s IRA, Nipps received a “Beneficiary’s Distribution Notice and Certification Form and Payment Instruction,” which stated that by signing, Nipps certified that he was aware that the distribution was subject to Federal income tax.

The Notice also stated that Federal income tax would be withheld by the distributor unless an election was made otherwise. Nipps signed and returned the notice but did not elect out of any withholding.

Nipps then deposited the funds into a newly established IRA account. Though on the surface this may constitute a successful “rollover” of the IRA distribution, the funds were taxable to Nipps in 2007 for two reasons:

1. While an IRA distribution is not includable in gross income if the entire amount received is paid into a qualified IRA within 60 days of the distribution, rollover contributions from inherited IRAs are specifically excluded from tax-free rollover treatment under Section 408(d)(3)(C). An individual can still avoid being taxed on the inherited IRA if the funds in the IRA are transferred from one account trustee to another account trustee without the IRA owner or beneficiary ever gaining control of the funds, but that was not the case here, as Nipps temporarily had control of the funds before depositing them in his own IRA.

2. On the same day he received the rollover contribution and deposited them in his IRA, Nipps inexplicably withdrew the $45,000, thereby defeating the purpose of establishing the IRA in the first place and rendering the entire previous paragraph moot, as IRA distributions are generally taxable.

Despite these two rather important pieces of information, Nipps failed to report the $45,000 as income on his 2007 tax return. The IRS predictably assessed a tax deficiency as well as an accuracy-related penalty under section 6662(a) and (b)(2) for a substantial understatement of income tax.

This is where the case took a rather unexpected turn, as the Tax Court sustained the deficiency assessment, but held that Nipps had reasonable cause for not reporting the income, despite the fact that he..you know…signed an affidavit certifying that he understood that the IRA distribution was included in taxable income. Thus, Nipps was not subject to the underpayment penalty.

The court explained its rather bizarre decision as follows:

Petitioner, who lacked knowledge and experience in tax law,reasonably believed that the correct Federal income tax would be withheld by Landmark Bank. He reasonably relied on Landmark Bank’s lack of withholding of Federal income tax as basis for his position that the distribution was not taxable…the Court finds that he had a reasonable basis to believe that the correct withholding would occur and that absent that withholding, the amount was not taxable.

So to summarize, Nipps’ inability to comprehend a one-page document that expressly provided that the funds he was receiving were taxable spared him from being assessed an understatement penalty. While this isn’t exactly groundbreaking, as taxpayer stupidity has always supported a reasonable cause defense to some degree, this would seem to establish a new low in what can best be described as the “slack-jawed yokel defense.”

A retired special agent with the IRS’s Criminal Investigation division has pleaded guilty to charges of transporting a California woman across state lines to Las Vegas for the purpose of prostitution.

Prosecutors agreed to drop one of the criminal counts against him for traveling to California with the intent to promote and manage prostitution. As part of the plea deal, Kemp Shiffer, 58, of Reno, Nev., agreed Wednesday to forfeit a 2006 Mercedes Benz, an iPhone, computer and various cameras.

Shiffer had been the lead IRS investigator of Joe Conforte, the owner of the notorious Mustang Ranch brothel, which led to its forfeiture to the federal government in 1990. The brothel was later auctioned off and sold to another operator. Later, Shiffer decided to get into the business for himself, and in 2006, he and his attorney invested in establishing another luxurious Nevada brothel known as Petticoat Junction. However, county officials denied them a permit to open it.

In a recent case, Estate of Paul Liljestrand , TC Memo 2011-259 (Tax Ct.), the IRS was once again successful in its attack of Family Limited Partnerships (FLPs). The Tax Court found in favor of the IRS and concluded the value of the assets of the FLP was included in the gross estate under IRC Sec. 2036(a).

The case provides a list of actions that we have discussed in previous posts of what high net worth taxpayers should avoid when implementing a FLP:

Management of the real estate owned by the decedent did not change from when the decedent owned the real estate in his revocable trust to when the real estate was owned by the FLP.

Although the FLP created in 1997 and legal title of the real estate was transferred to the FLP, the income from the real estate was deposited in the revocable trust of the decedent.

Partnership tax returns for the FLP were not filed until 1999. The income from the real estate was reported on the decedent’s individual income tax return in 1997 and 1998.

Although the decedent made gifts of interests in the FLP to irrevocable trusts for the benefit of his children that exceeded the available annual exclusion, gift tax returns were not filed until after the decedent’s death.

The decedent retained insufficient investments outside of the FLP to pay for his personal living expenses and used the income from the real estate in the FLP to pay for personal expenses.

There were disproportionate distributions of cash flow to the decedent.

And finally, the investments in the FLP were used to pay the estate tax of the decedent.

The Tax Court concluded that the FLP was “created principally as an alternate testamentary vehicle to the trust and that the decedent retained enjoyment of the contributed property within the meaning of IRC Section 2036(a).”

What can be learned from the case: When implementing a FLP, it is very important to document the non-tax reasons for formation. In addition, the FLP cannot be the personal piggy bank of the individual creating the FLP and the individual should only fund the FLP with investments not needed to meet personal expenses.

The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation. A select group of Tax Professionals of WithumSmith+Brown write Double Taxation, and any opinions expressed or implied are not necessarily shared by anyone else at WithumSmith+Brown.

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